3 Questions About Investment Risk

2011 was a wild year in the stock and bond markets—and many investors are focusing more intently on risk. But this notion of risk is a tricky one. To understand why, ponder these three questions:

…if owning stocks causes you sleepless nights, you should probably hold more bonds, even though your long time horizon suggests stocks are an appropriate investment.

How much risk can you reasonably take? To get an answer, you would probably want to consider a range of factors, including how far off your investment goals lie, how much your paycheck fluctuates, how secure your job is and how much—if any—income you need from your portfolio.

Let’s say you’re saving for retirement. You might favor a stock-heavy portfolio when you are younger. But as you approach retirement and your final paycheck, you might lighten up on stocks and instead shift toward bonds and other income-generating investments.

How much risk can you stomach? When you’re in your 20s, investing heavily in stocks may be the rational strategy. But if owning stocks causes you sleepless nights, you should probably hold more bonds, even though your long time horizon suggests stocks are an appropriate investment.

How much risk do you need to take? Imagine that, with more investment experience, you become comfortable owning stocks. In fact, thanks to some wise investing and diligent saving over the prior two decades, you accumulate a substantial portfolio by your 40s.

Because you’re now at ease owning stocks and you still have a reasonably long time horizon, a stock-heavy portfolio might seem like the obvious choice. But this isn’t necessarily the right strategy.

Why not? If you already have a large nest egg, you may be able to hold a conservative portfolio and still amass enough for retirement. To be sure, you might opt to invest heavily in stocks in pursuit of higher returns. But in terms of reaching your goals, you may be taking more risk than is necessary.